Macroeconomic and financial market commentary

One last print to come. Maybe a lot more.

“The return to monetary stability does not generate a crisis. It only brings to light the malinvestments and other mistakes that were made under the hallucination of the illusory prosperity created by the easy money. (Ludwig von Mises)”

The Fed’s trip to financial stability.

To anybody who has read Mises in depth, it was glaringly obvious that the road back to monetary stability would be treacherous. Regrettably, the date when we would get going with that uncomfortable transition was not predictable beforehand. Ever since Ben’s no-show in June 2014 (as a consequence of the taper tantrum), lots of confusing and contradictory fed-speak made it difficult to pinpoint the exact moment when they would go for monetary normalization.

It took Stanley Fischer well over a year to convince Janet and colleagues that rates had to take off soon. At long last, they did it last December.Good. We now know where we are, and what they are trying to do at the FOMC. Fisher or Williams have made it very clear, and even the most dovish members were not standing up against a suggested series of three to four rate hikes through 2016. Janet Yellen recently reiterated their commitment to normalization. Their mood will change in due time. In fact, it changes as I write. Back-pedalling is already real at least referred to interest rate hikes. More printing is hopefully not being contemplated… Yet!

“A weakening of the global economy accompanied by further appreciation in an already strong dollar could also have “significant consequences.” … We’re acknowledging that things have happened in financial markets, and in the flow of the economic data, that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward.” (Bill Dudley 02.03.2016).

I think it is safe to assume that, for the time being, they are going to try to stick to their course and normalize monetary policy -for financial stability reasons. And they are trying to normalize asset values as well.In Fischer’s own words: “if asset prices across the economy -that is, taking all financial markets into account- are thought to be excessively high, rising interest rates may be the appropriate step”. And he added, “the Fed should be open in the future, to raising interest rates to ward off potential asset bubbles”. I read him loud and clear, and it’s a nice change since Bernanke and Yellen last said that monetary policy was not the right way to avoid them.

Even if this reassuring talk comes at the eleventh hour, it is comforting to listen to Stanley Fischer. He means what he says, so we have to assume their commitment to a gradual tightening in the USD. And a tightening in the global reserve currency impacts us all. Together with that, the good news is thatthey now belatedly admit that the tightening is not really focused on business cycle related requirements. Rather, it is financial stability and risk building concerns that motivate the lift off. Is this as good as Fed-speak can get?

You never know. Anyway, regarding what we have already seen, I am not sure you can say better late than never this time around. There is no easy way out of the plateau of asset overvaluation, and accumulated debt increase, that easy money has engendered. I think a meltdown is inevitable. The deflationary forces unleashed by the tightening in liquidity and higher rates will lead us to financial disorder, and a financially induced recession, and make it necessary to print at least once again. Unless we want to allow the ATM network to run out of paper money!

The situation in Japan and China.

All the way to Japan and a growing minority of Kuroda-san’s crew is making all kinds of noises to show their uneasiness about the BOJ sponsored crazy JPY printing orgy. Their discomfort became apparent when the umpteenth easy policy move was voted in January. A meager surplus of one vote is all Kuroda managed to squeeze out of his Politburo comrades. They concluded reassuring markets that they will keep on printing as usual, and opted for NIRP in order to spice up their maddening Keynesian cocktail. If Abenomics wasn’t working as expected, it must be that they need more of the same. Ugly reasoning again. Chart from acting-man website.

Thank God, their decision was not unanimous by a long shot, in fact, it was the slimmest of majorities. Not everybody is insane at CB politburos. Unfortunately, the decision has already been made, and some relevant consequences deserve mention.

First of all, it induced a much-needed jump in worldwide oversold equity markets. A rally that was obviously meant to be faded at some point, but in the meantime, the remainder of the CB pack took their chance to inflate prices as much as they could. I am against market interventions by CB’s, particularly if they are covert or stealth interventions. If they are going to trade they should make the trade size, and direction of the trade, clear to all. Otherwise, we end up with rigged markets. But I do think CB’s should strive to ensure liquidity and contain volatility above certain thresholds. We have to bring asset values down, but we have to do that in an orderly fashion.

A sharp but brief devaluation of the yen ensued and caught a significant amount of professionals short the USDJPY pair (long the JPY). It does look as if this is going to be another bad year for macros and hedge funds. They got whipsawed once again. I never felt comfortable shorting the USDJPY pair, but had I felt differently I would likely be licking my wounds as well. It makes you think. Is this CB rigged market a level enough playground in which it is worthwhile playing?

Macroeconomic effects of this measure will be negative in the long run. Right now, it is not only about printing or nirping, but also about the value of the trade weighted USD. Revaluing, or working to revalue the USD against the yen, you tighten global financial conditions further.Printing and easing have to be done in USD from now on (until the USD short is resolved). Printing and nirping other currencies only add to the USD shortage problem. This is not a problem now -due to the move in the USDJPY pair- but potential relative dollar strength will not help further down the road.

The Chinese are not a lot better off. In fact, I think their prognosis is the worst of the lot. They have tried to prevent meaningful credit growth (they always print Chinese style, stimulating credit growth, and targeting the M2 level), and are doing their best to change their economic model (or so they say). They would forcefully reign in credit if they didn’t feel that the stock market, currency, and real economy are, to say the least, shaky. Their balancing act is awesome, I wonder how long will they be able to keep it up.

My view is that their economy will implode sooner or later (chart zero hedge). Maybe much later, but the trade-weighted CNY and CNH are on a preset course to a trade-weighted 20% devaluation or more. Soros is right. The problem is that it is very difficult to short CNY -because the swap cost is prohibitive. Last time I checked, it cost circa three hundred basis points for a six-month forward short in the CNY.

I repeatedly read the same wishful thinking narrative when diagnosing Chinese economic prospects.

The economy is being transformed from an investment and export-led economy to a consumer-led economy, and it is just a question of being patient enough. Perhaps. Nevertheless, I doubt an economy can glide naturally and uneventfully from one model to the other.

Their huge reserves are a powerful protection against currency devaluation tensions and NPL growth. NPL’s can easily be handled against reserves. My take on this one: not a chance in a thousand!

A ten trillion USD sized economy does not turn on a dime. I find it naive to think that you can transition between two entirely different economic growth models -with only some minor bumps on the way- while keeping growth above the 6% level. Nonetheless, it very well could be the case, nothing is impossible.

But I won’t take any nonsense when trying to minimize the risks imposed by a surge in NPL’s. Assets in their banking system are thirty-five trillion. As Kyle Bass puts it, It only takes a run of the mill recessionary NPL ratio of 10% to generate 3.5 trillion USD in losses. Total reserves are well below the three trillion level, and, naturally, they can’t gobble them all up just to offset the NPL figures, they need some to run their economy. Anyway, you look at it, their economic future is awful. That is exactly why they are all trying to get their money out.

People take their money out of their country for a reason. It is normally a good reason: they live there and are likely to have some local know-how on the real economy. Not even a massive dollar print by the Fed would spare the Chinese government their moment of truth. Economic miracles do not exist. We are talking trillions in bad loans once the party is over. Subprime in 2008 was child’s play compared to their NPL issue. A very hard landing is well baked in the cake by now.

The old continent.

Looking up Europe, it pays to remember that Mario and friends were late to the printing party. Maybe it is for that reason, that they still show their grandiose commitment to increase QE -and considering all their rhetoric, the odds favor expecting some hard facts to follow suit. The European monetary base has not reached any practical limits yet. I think they will keep nirping and printing until the end: Stanley Fisher doesn’t work there.

They keep trying to devalue the euro, selling the USDEUR pair (directly or indirectly) as well. But if they revalue the trade weighted dollar, they are making matters worse for themselves -and for everybody else as well. They don’t get it. Or maybe they do understand, but don’t care. Any dollar appreciation will tighten financial conditions further, and it will add to the pressure on the PBOC. If the yuan goes, other EM currencies will follow suit, and Germany, the European export powerhouse, will suffer considerably. Lastly, take my word for it, the yuan will go! You can’t beat gravity for long.

It is perhaps fitting that devaluing the euro they would, in fact, contribute to global tightening through a tighter USD, and consequently induce European economic weakness, that would, in turn, devalue the euro further.

The USD trade-weighted rise has been moderated up to now by the year long stability of the EURUSD and the USDJPY pair. A strong USD tightens monetary policy for all of us, because, like it or not, it is the base currency for international trade. On top of that, the dollar short we have been talking about for more than a year is still there. It looks ominous to me (chart by the daily shot).

The ECB board has to be careful about having too much of a good thing. Not long ago Draghi was imploring markets to help him save the euro when nobody wanted to hold it. One of those ironic twists of destiny. I love them.

Financial markets in this context.

So most of the CB’s are out or phasing out, their printing addiction, with the relevant exception of the ECB. And the FED is even trying to get rates above zero and close to 1% (three to four 25 bps hikes) as well. How can anybody expect markets to thrive?

Yes, I know the market obviously thinks different about rate rises, and as I write this, additional tightening has been removed from prices in USD money markets. Notwithstanding this discrepancy, it is fair to say that a lot of uncertainty has been taken out of the market. The market is hinting that easy money is finished, and consequently, an asset price correction ensued almost immediately. Investors face a lose-lose proposition: if markets are calm they will tighten further, and if they collapse they might give you a handout. I don’t think long only -for the Siegel long run- is an interesting proposition at all! Best case scenario is you don’t lose money!

As the correction becomes deeper, and a scent of panic was present in the move of the S&P 500 to the 1800 level (for a second time), the value of just two economic variables accounts for most of the market angst today: interest rates and easy money. The hypothetical abandonment of the rate hike road map, and better still, some possible new printing by CB’s, are variables now prominent in everybody’s early alert system. Investors are hoping, if not begging (Jeff Gundlach, Kyle Bass) the US cavalry to ride to the rescue once again. But it won’t be that easy the next time.

The Fed continues to hold back on a fresh round of printing. They cannot back-step on their recent tightening. Unless… unless financials and commodities markets collapse. They know by now, that printing again will only provide a short respite. Still, they are nervous, A leftover of Greenspan’s and Bernanke’s put is embedded in their politburo conformed minds.

In the meantime, and for as long as it takes them to make up their mind, the direction of prices in equities, HY, and insolvent sovereigns is down. Moreover, the direction of risk-free interest rates (ie bunds, treasury rates) is down as well -provided a liquidity surge does not change the actual scenario. Credit spreads will continue to widen.

There will be some bear market rallies along the way, while on some days we will see some major corrections. CB’s ought to remain calm and hold their fire for as long as they can. They are short of ammo and must make sure the last bullet round counts. It will be difficult for Central Banks to do that. But that is exactly what they ought to do, sit back and see what happens when you create credit booms -credit busts inevitably follow, sooner or later.

The day of reckoning comes closer.

Unless the Fed prints early, this sell-off will go on -until panic takes control of financial and commodities markets. Now is the time for Fisher and Yellen to show their emotional control. If they print too early, before balance sheets have been cleaned up substantially, it guarantees a series of printing episodes that will take us all the way into hyperinflation. Fiat currencies will be worth less than toilet paper. One print will take us to the next because the economy will fail to heal.

They have to hold their fire until they can see that a total wipe out of debt is inevitable. Then, and not before then, they have to engage in one last print.They ought to print whatever amount is needed to ensure that ATM’s continue to work smoothly, but no more. It is essential that this print does not bail out investors or banks, or allow for zombie companies to be kept afloat. We are long overdue a massive supply side clean up, particularly in the financial sector. We also have to clean up greedy investors, dumb fund managers etc. Schumpeterian creative destruction tops the list of “to do’s” in order to engage in a brand new business model for our global economy -with a decently clean start. A new economic model that is not based on debt or constant currency debasement.

In this last print, they ought to bail out depositors to ensure the global network of ATM’s keeps working, but only after all investors holding bank Contingent convertibles, subordinated debt, or shares have been bailed in. We have to ensure that this last print becomes, and is perceived by everybody, the last fiat money major debasement.

So, yes, we will have to print again and it is up the members of the FOMC’s to decide if they are to engage in indefinite endless printing, bailing out the economy and markets for as long as they can, or save the printing presses for one last and final print. It will be a large print.

Let’s sum it all up. In order to achieve a clean start to a new era, we have to make sure that:

Leverage disappears in a massive, default driven, balance sheet clean up. No balance sheet problems should be left for the future. We have to get rid of massive indebtedness for real. Or else, we will be printing again in a couple of months.

Investors ought to receive a lesson on risk evaluation -and moral hazard is to be avoided for that.

They should print and spend the minimum amount of money that is needed to ensure the financial system continues to work for ordinary cash related transactions. No inequality widening once again: the rich should be left on their own. We must save depositors, not investors or bank owners.

From then on, we should anchor our fiat currencies to gross output, establishing strict limits on credit, M2 or M1 levels that will be kept anchored against gross output. We do not have to fight inflation, we have to fight credit growth and monetary debasement, and deflationary or inflationary episodes will be mild enough to take care of themselves.

Remember to emphasize the return of your money over the return on your money. Remember, debts have to be cleaned up, and defaults will be pervasive. Remember those fallen angels will affect lower grade bonds, that ERP’s will be impacted, that profit growth is already scant, and do not forget that the financial collapse will push profits down. Currency-wise stick to the best fundamentals available. Good luck with your banks, none of them is 100% safe. Do not average down on anything you hold, and beware false dawns, unless they print at the Fed.

It ain’t over till it’s over. And this is just the “beginning of the end” of easy money and rigged pricing.Hold tight because, with lots of new printing, or just one more, this is going to be one hell of a ride. Those guys at Zero Hedge are good (see chart underneath). I just wish they weren’t so goddamn biased. I like to see both sides of the trade even if I despise Central Bankers every bit as much as they do. Their chart underneath makes sense. It is a realistic target down the road. I am a firm believer in credit spreads, as a leading indicator for future equity pricing. And credit spreads are just not going to recover significantly before this is over and done with.